Post-Keynesian Ideas For A Crisis That Conventional Remedies Cannot Resolve

Tag Archives: sectoral balances

The Jan Hatzius interview on sectoral balances mentioned in the previous post – although has given it some popularity – has led to great confusions among economic commentators.

Here is a confused Professor from the famous institute INSEAD – Antonio Fatás on his blog.

Fatás implicitly denies that propensities to consume/save and government expenditure and taxing decisions have any impact at all on demand and hence output.

I quote from his blog. The quote includes that of Hatzius’ interview (in italics):

[Hatzius] “That’s the starting point. It’s a truism, basically. Where it goes from being a truism and an accounting identity to an economic relationship is once you recognize that cyclical impulses to the economy depend on desired changes in these sector’s financial balances. If the business sector is basically trying to reduce its financial surplus at a more rapid pace than the government is trying to reduce its deficit then you’re getting a net positive impulse to spending which then translates into stronger, higher, more income, and ultimately feeds back into spending.”

[Fatás] This paragraph is misleading (I will ignore again the fact that in an open economy things are more complex). It states (at least this is the way I read it) that growth depends on the “desired changes in these sector’s financial balance”. This is not correct. I can imagine an economy where those financial balances are not changing at all where output is growing very fast (and I can also imagine another one where output is collapsing). There is no connection between growth and these financial imbalances. As long as demand (private or public) is feeding into production and income, the private or public sector might be spending more than last year but their income is also increasing which can make the financial balance remain at the same level as before.

Jan Hatzius is discussing a model of business cycles and growth in the medium term – such as a year or two. But for Fatás, “this is not correct” and “there is no connection between growth and these financial imbalances”! He claims that demand can be feeding into production and income but doesn’t realize that a change in financial balances caused by say a change in the propensity to save or consume itself leads to changes in the source of demand.

Fatás is thinking of a situation – a type of a long run situation where the parameters in the models are not changing and there is high growth. But that does not mean “there is no connection between growth and these financial balances”. A spontaneous change in one or few parameters (such as the propensity to consume) or an exogenous change in the government expenditure changes financial balances and affects the growth rate.

But these things do not matter for him:

If we believe that we are in a situation where the output gap is large, there are unused resources and, as a result, output is determined by demand, what matters for growth is whether demand increases relative to last year and not so much the change in the desired changes in the financial balances of either the private or public sector.

Again forgetting that desired changes in the financial balances affect the sources of demand.

Somehow basic notions of the Keynesian principle of effective demand are difficult for economists to understand.

BI: Back to the balance sheet, multi-sectoral framework of looking at the economy. How did you come to this view? On Wall Street this is still very rare. I don’t see many economist talk about the economy this way, recognizing this identity and making projections based on it. How did you come to see this as the framework by which we should be looking at the economy right now?

HATZIUS: I’ve long been fascinated with looking at private sector financial balances in particular. There was an economics professor at Cambridge University called Wynne Godley who passed away a couple of years ago, who basically used this type of framework to look at business cycles in the UK and also in the US for many many years, so we just started reading some of his material in the late 1990s, and I found it to be a pretty useful way of thinking about the world.

It’s usually not something that gives you the secret sauce at getting it all right, because there are a lot of uncertain inputs that go into this analytical framework, but I do think it’s a reasonable organizing framework for thinking about the short to medium term ups and downs of the business cycle.

Basically, in order to have above trend growth, a cyclically strong economy, you need to have some sector that wants to reduce its financial surplus or run a larger deficit in order to provide that sort of cyclical boost, most of the time.

There are other factors at play in the business cycle – I’m certainly not claiming that ‘this is it!’ – but I have found it to be pretty useful.

He has a nice way of giving a short description of pricing in the G&L models:

In my view, the stock-flow and the demand driven (and I should say, the fact that price dynamics is orthogonal to the income flow determination structure) is the essential characteristic of this approach.

—

Also, Simon Wren-Lewis (from Oxford) has a new blog post on the sectoral balances approach – Sector Financial Balances As A Diagnostic Check, where he mentions Martin Wolf’s recent post on Wynne Godley’s approach. He (Wren-Lewis) has been admitting recently that DSGE models are not useful.

In the comments section Simon Wren-Lewis has this to say:

Martin Wolf sent me the following comment, which I am sure others will also find interesting:

“I used sectoral financial balances before the crisis, following Wynne. I argued that what was going on in the US external and household sectors were evidently unsustainable. This allowed me to argue that when the latter’s deficits were eliminated, there would be a recession and a huge fiscal deficit. What I had not expected was that the turnaround in the household sector would trigger a meltdown of the financial system.

“This makes it clear that one has to link the flow sectoral balances to the balance sheets in the economy. In this case, my mistake was not looking closely enough at the balance sheet of the financial sector. Good macroeconomic analysis has to examine the flows and stock meticulously and seek to assess whether the behaviour we see is sustainable. The assumption that private agents cannot make huge mistakes about the sustainability of what they are doing is, in my view, the biggest mistake in macroeconomics.”

Back to DSGE models. I think they are totally useless. I like this quote by Francis Cripps from an article in The Guardian from 27 Feb 1979: Economists With A Mission:

… I look at this through the lens of “sectoral financial balances”, an analytical framework learned from the work of the late Wynne Godley. The essential idea is that since income has to equal expenditure for the economy, as a whole, (which is the same things as saying that saving equals investment) so the sums of the difference between income and expenditures of each of the sectors of the economy must also be zero. These differences can also be described as “financial balances”. Thus, if a sector is spending less than its income it must be accumulating (net) claims on other sectors.

The crucial point is that, since sectoral balances must sum to zero, a rise in the deficit of one sector must be matched by an offsetting change in the others. It follows that if the fiscal deficit is increasing, the sum of the surpluses of the other sectors of the economy must be increasing in a precisely offsetting manner.

These are tautologies. But the virtue of this framework is that it forces us to ask what drives what: are, for example, fiscal deficits in the US (or UK) driving the surpluses in other sectors or are the surpluses in the other sectors driving the fiscal deficit? We can obtain answers by examining what behaviour is changing…

and that:

… The idea that the huge fiscal deficits of recent years have been the result of decisions taken by the current administration is nonsense. No fiscal policy changes explain the collapse into massive fiscal deficit between 2007 and 2009, because there was none of any importance. The collapse is explained by the massive shift of the private sector from financial deficit into surplus or, in other words, from boom to bust…

The sectoral balances approach should always be handled with supreme care. There are causalities running in all directions and one needs to ask what brings them to equivalence, what the value of policy instruments are, how is output changing etc.

Although the three balances must always sum to exactly zero, no single balance is more a residual than either of the other two. Each balance has a life of its own, and it is the level of real output that, with minor qualifications, brings about their equivalence. Underlying the main conclusions of our reports is an econometric model in which exports, imports, taxes, and private expenditure are determined as functions of such things as world trade, relative prices, tax rates, and flows of net lending to the private sector. However, neither the knowledge that this is the case nor the perusal of any list of econometric equations will, on its own, impart any intuition as to why output moved as it did over any set period.

It is well known to students of the National Accounts that the surplus of private disposable income over expenditure is equal to the government balance (written as a deficit) plus the current balance of payments (written as a surplus). While these balances are related to one another by a system of accounting identities, each has, to some extent, a life of its own that is reconciled with the other two via the aggregate income flow. The way the balances evolve provides a useful armature around which to organise a narrative account of economic developments, because any one of them is necessarily implied by the other two. Furthermore, the balances may give an early warning that unsustainable processes are taking place, for any high or rising balance implies a change in public, private, or foreign debts, which cannot grow without limit relative to income.

Wynne Godley with his CEPG partner Francis Cripps (from Cambridge Group Sings The Blues, The Guardian, 17 April 1980)

Of all the economists, Wynne Godley had the rarest of rare ability to model and imagine the economic dynamics of the whole world. “… a full macroeconomic model in his head, which, by some sort of subconscious process, he computed.” as his obituary from FT said.

I obtained this original scanned copy of the paper Seven Unsustainable Processes – Medium Term Policies For The United States And The World by Wynne Godley from 1999 from the Levy Economics Institute and thought that since this version is missing for some reason from the levyinstitute.org website, I’ll post it here (after asking them if I may post).

Click to see the pdf.

Seven Unsustainable Processes from 1999

Here’s the link to the updated version of the paper from the year 2000. The original had a typo. Two columns in Table 1 appeared with incorrect headings (should have been the reverse).

Wynne Godley at the Levy Institute

Godley warns of the private sector indebtedness:

… Moreover, if, per impossibile, the growth in net lending and the growth in money supply growth were to continue for another eight years, the implied indebtedness of the private sector would then be so extremely large that a sensational day of reckoning could then be at hand.

Wynne Godley never liked the chimerical and primitive view of economists where anything and everything is traded in the markets via supply and demand. So,

The difference between the consensus view and that put forward here could not exist without a profound difference in the view of how the economy works. So far as the author can observe, the underlying theoretical perspective of the optimists, whether they realize it or not, sees all agents, including the government, as participants in a gigantic market process in which commodities, labor, and financial assets are supplied and demanded. If this market works properly, prices (e.g., for labor and commodities) get established that clear all markets, including the labor market, so that there can be no long-term unemployment and no depression. The only way in which unemployment can be reduced permanently, according to this view, is by making markets work better, say, by removing “rigidities” or improving flows of information. The government is a market participant like any other, its main distinguishing feature being that it can print money. Because the government cannot alter the market-clearing price of labor, there is no way in which fiscal or monetary policy can change aggregate employment and output, except temporarily (by creating false expectations) and perversely (because any interference will cause inflation).

No parody is intended. No other story would make sense of the assumption now commonly made that the balance between tax receipts and public spending has no permanent effect on the evolution of the aggregate demand. And nothing else would make sense of the debate now in full swing about how to “spend” the federal surplus as though this were a nest egg that can be preserved, spent, or squandered without any need to consider the macroeconomic consequences.

The seven unsustainable processes were:

(1) the fall in private saving into ever deeper negative territory, (2) the rise in the flow of net lending to the private sector, (3) the rise in the growth rate of the real money stock, (4) the rise in asset prices at a rate that far exceeds the growth of profits (or of GDP), (5) the rise in the budget surplus, (6) the rise in the current account deficit, (7) the increase in the United States’s net foreign indebtedness relative to GDP.

As it happened, the United States went into a recession but recovered quickly because of further deregulations and low interest rates which led to more borrowing, and a fiscal stimulus which put a floor on the downfall. However, the private sector went back into deficits and its indebtedness kept rising relative to income. The current balance of payments also went deeply in deficit rising to about 6.43% at the end of 2005 – hemorrhaging the circular flow of national income at a massive scale. See the related post here: The Un-Godley Private Sector Deficit.

Not only did Godley see the crisis coming, he also figured out that the United States will soon run into policy issues and will have less room to come out of a crisis. In this 2005 strategic analysis paper The United States And Her Creditors – Can The Symbiosis Last? he and his collaborators (Dimitri Papadimitriou, Claudio Dos Santos and Gennaro Zezza) pointed out that:

The range of strategic policy options for the United States is beginning to narrow … As the normal equilibrating forces (changes in exchange rates) are being subverted, it is very far from obvious what the United States can do on her own …

The prospects for the U.S. economy have become uniquely dreadful, if not frightening. In this paper we argue, as starkly as we can, that the United States and the rest of the world’s economies will not be able to achieve balanced growth and full employment unless they are able to agree upon and implement an entirely new way of running the global economy.

Stressing the need for concerted action (from which I got the title of my blog!), the authors said:

… Fiscal policy alone cannot, therefore, resolve the current crisis. A large enough stimulus will help counter the drop in private expenditure, reducing unemployment, but it will bring back a large and growing external imbalance, which will keep world growth on an unsustainable path …

… What must come to pass, perhaps obviously, is a worldwide recovery of output, combined with sustainable balances in international trade. Since this series of reports began in 1999, we have emphasized that, in the United States, sustained growth with full employment would eventually require both fiscal expansion and a rapid acceleration in net export demand. Part of the needed fiscal stimulus has already occurred, and much more (it seems) is immediately in prospect. But the U.S. balance of payments languishes, and a substantial and spontaneous recovery is now highly unlikely in view of the developing severe downturn in world trade and output … By our reckoning (which is put forward with great diffidence), if the United States were to attempt to restore full employment by fiscal and monetary means alone, the balance of payments deficit would rise over the next, say, three to four years, to 6 percent of GDP or more—that is, to a level that could not possibly be sustained for a long period, let alone indefinitely …

… It is inconceivable that such a large rebalancing could occur without a drastic change in the institutions responsible for running the world economy—a change that would involve placing far less than total reliance on market forces.

Discussions of the U.S. public debt and fiscal deficits curiously miss on the connection with the external sector. Even the Congressional Budget Office (CBO)’s The Budget And Economic Outlook report misses this connection when projecting the public debt over many scenarios.

Last week the President of the Federal Reserve Bank of New York, William Dudley gave a speech at a “Panel Discussion on Fiscal Challenges” and the two topic discussed by him were: the interest expense of the US government on its debt and the U.S. sectoral balances.

According to him, “we are in an unusual period in which net interest expense is temporarily depressed”. You can read about it at the FRBNY web page of the speech.

Which brings me to his discussion on sectoral balances. This is not the first time he has talked on this and the public debate on the public debt and fiscal deficit of the United States almost always miss the important connection of this with the external sector imbalance. But Dudley knows the importance of this in policy making, even though he begins his talk by saying that discussion of fiscal policy “for central bankers [is] always dangerous waters to swim in”.

Here’s Dudley’s chart:

Let’s just say Dudley is less dogmatic about fiscal policy than his colleagues because he says:

Fiscal adjustments require offsetting changes in private-sector spending and saving behavior, and in the trade sector. Prudent economic policies and international coordination can help ensure that such adjustments take place in ways that support economic activity (and, by extension also support government revenue).

and

On one hand, the U.S. economy must be reoriented toward global demand and stronger net exports. On the other hand, there will have to be offsetting adjustments elsewhere in the world. After all, on a global basis, the current account balance—properly measured—must sum to zero. This means that countries with significant trade surpluses will need to reorient their economies over time toward increasing domestic demand and running smaller trade surpluses.

Economists worry too much about the government’s deficit although they seem to not know about the private sector deficit.

Goldman Sachs’ chief economist Jan Hatzius came to know about the sectoral balances approach and called the difference between United States’ private expenditure and income in “The Un-Godley Private Sector Deficit”. He later included the sectoral balances approach in his forecasting models.

Here’s the sectoral balances for the United States using data from the Federal Reserve’s Z.1 Flow Of Funds Accounts Of The United States:

GDP appears in Table F.6 and sectoral balances in Table F.8 – as “Net Lending(+)/Net Borrowing(-)”. The above is using quarterly seasonally adjusted data. Easy work. Excel data is available at the Federal Reserve’s page here

The red line is the private sector balance and is the difference between the private sector income and expenditure. When positive, the private sector is in surplus and when negative, it is in deficit.

For most of history having been positive (and back to being positive now), the private sector balance made a dramatic shift in the mid-1990s reaching as low as as -5.8% in Q1 2000 (and hence “private sector deficit”). This implied that before the recession, growth in the United States was driven by higher private expenditure relative to income. The flip side of this growth was that due to the Un-Godley private sector deficits, the budget went into a surplus while private indebtedness continued to rise.

This was enough to cause a recession in the early 2000s and the US government had to provide a massive fiscal stimulus to prevent a severe recession. The Federal Reserve also provided stimulus by keeping interest rates low but the private sector went into a deficit again – rushing to participate in a boom. The result of all this was the increase in the current account deficit of the United States to about 6.43% of GDP at the end of 2005 – hemorrhaging the circular flow of national income at a massive scale and cracks started to appear in the foundations of growth – as warned by a series of articles from the Levy Institute.

This appears a bit like Scenario 4 in a Levy Institute paper Debt And Lending – A Cri De Coeur by Wynne Godley and Gennaro Zezza from April 2006 – the “gloomiest variant” according to the authors – where a drastic fall in private expenditure relative to income induces a recession in the United States, reducing the current account balance dramatically and increasing the budget deficit (to eventually enough to become the central debate in US politics).

And it turned out that the private sector deficit quickly went into a surplus – faster than the scenario presented above because the private sector could not handle the rise in indebtedness. The fall in private expenditure relative to income also meant – as mentioned above – that the United States went into a deep recession – from which it is still recovering.

Now, “saving net of investment” is sometimes called “net private saving”, although the originators such as Wynne Godley always specified this.

I guess the the root of the confusion on the part of those who have inherited this terminology from the originators is to treat the “net” in net private saving as a result of netting due to aggregation alone, and take the sectoral balances identity – whereas the “net” is crucially net of investment.

In a recent post Income And Expenditure Flows And Financing Flows, I went into concepts such as saving, saving net of investment, net acquisition of financial assets, net incurrence of liabilities, and “net lending(+)/net borrowing(-)” and you may read the example there on the calculation of these flows. I also went into clarifying this by an example but let’s just check this for the case of the United States with actual data from the Federal Reserve Z.1 Statistical Release Flow Of Funds Accounts Of The United States from the historical data from 1995-2004 available here. In particular the table F.8.

In the above, the data highlighted in blue is the current account balance. With the whole nation’s expenditure higher than income, it’s net lending was negative – i.e., it was a net borrower (from the rest of the world).

Also, the government budget was in surplus in the years (line 49 highlighted in red).

Also, here’s the part which has the potential to create more confusions. The Net Saving defined by the flow of funds accountants is Saving net of Consumption of Fixed Capital (i.e., depreciation). So this can be checked from items highlighted in yellow.

So, the private sector had a positive saving even though the budget was in surplus and the current balance of payments in deficit!

Of course, this meant that the private sector financial balance is negative and this you can see in line 43 highlighted in Red.

Readers of this blog may be aware of my fanhood for Wynne Godley and the title of this post is from a paper by him from 2004, although it was US-centric. This post is on imbalances in the Euro Area.

Wynne had not only always foreseen crises, but also knew about the muddle in the public debate and in academia both before and after the crises and the policy space available to resolve the crisis. Here’s from the short paper:

The public discussion is fractured. There are vacuous suggestions coming from sections of Wall Street that Goldilocks has been reincarnated and everything is fine. There are right-wing voices calling unconditionally for cuts in the budget deficit. The Bush administration seems complacent and, thank goodness, is not being convinced about cutting the federal budget deficit any time soon. Many are concerned about the current account deficit. Some of them fear a big and “disorderly” devaluation of the dollar while others think the dollar isn’t falling enough. No one has a clear idea about what can actually be done, by whom, and when. I have no sense that anyone who pontificates on these matters (outside the Levy Institute!) does so with the benefit of a comprehensive stock-flow model—the indispensable basis for competent strategic thinking.

In his 1983 book Macroeconomics, with Francis Cripps, he wrote:

… Our objective is most emphatically a practical one. To put it crudely, economics has got into an infernal muddle. This would be deplorable enough if the disorder was simply an academic matter. Unfortunately the confusion extends into the formation of economic policy itself. It has become pretty obvious that the governments of many countries, whatever their moral or political priorities, have no valid scientific rationale for their policies. Despite emphatic rhetoric they do know what the consequences of their actions are going to be. Moreover, in a highly interdependent world system this confusion extends to the dealings of governments with one another who now have no rational basis for negotiation.

Eurostat, the statistical office of the European Union published for the first time today the indicators of the “Macroeconomic Imbalances Procedure Scoreboard”.

The Headline Indicators Statistical Information release provides detailed data (since 1995) for current account imbalances, the net international investment position, share of world exports, private credit flow (net incurrence of liabilities discussed in the previous post), private debt and the general government debt for the EU27 countries not just EA17. People a bit familiar about Post Keynesian Stock-flow coherent macro models will be aware of the connection between these.

The flow accounting identity

NL = PSBR + BP

where NL is the Net Lending of the private sector to the rest of the world, PSBR is the Public Sector Borrowing Requirement, equal to the government’s deficit and BP is the current balance of payments (or simply the current account balance) adds to stocks of assets and liabilities via the short-hand equation (also mentioned in the previous post)

Closing Stocks = Opening Stocks + Flows + Revaluations

and hence the connection between the stocks and flows mentioned by Eurostat. The report also provides data for Real Effective Exchange Rates, Normal Unit Labour Costs, evolution of House Prices (which rise faster in booms and do the opposite in busts) relative to prices of final consumption expenditure of households.

The Euro Area was formed with the “intuition” that by having a single currency, among other advantages – the nations would not have balance-of-payments problems at all.

Wynne Godley saw this muddle as early as 1991:

(click to expand in a new tab)

Writing for The Observer where he said:

… But more disturbing still is the notion that with a common currency the ‘balance or payments problem’ is eliminated and therefore that individual countries are relieved of the need to pay for their imports with exports.

Quite the reverse: the existence or a common currency makes a country more directly dependent on its ability to sell exports and import substitutes than it was before, particularly as it will then possess no means whereby it can (in the broadest sense) protect itself against failure.

and that:

… If we are to proceed creatively towards EMU, it is essential to break out of the vicious circle of ‘negative integration’— the process by which power is progressively removed from individual governments without there being any positive, organic, all-European alternative to transcend it. The nightmare is that the whole country, not just the countryside becomes at best a prairie, at worst a derelict area.

The Eurostat is a statistical organization and its job is to report and maybe suggest some policies to the policy makers. It has rightly identified the imbalances which are looking for a policy. Unfortunately, these imbalances are typically brought to a balance (or at least attempted to) by deflating demand and hence reducing output and increasing unemployment. The recent treaty changes with a new “fiscal compact” shows what the policy makers are trying to do. But they do not realize its implications!

Here’s from a 1995 articleA Critical Imbalance in U.S. Trade written by Godley:

Refuting the “Saving is Too Low” Argument

It is sometimes held that, in the words of the Economist (May 27. 1995, p. 18), “America’s current account deficit is enormous because its citizens save so little and its government spends too much.” The basis for this proposition is the accounting identity that says that the private sector’s surplus of saving over investment is always equal to the government’s deficit plus (or minus) the current account surplus (or deficit). As this relationship invariably holds by the laws of logic, it can be said with certainty that if private saving were to increase given the budget deficit or if the budget deficit were to be reduced given private saving, the current account balance would be found to have improved by an exactly equal amount. But an accounting identity, though useful as a basis for consistent thinking about the problem can tell us nothing about why anything happens. In my view, while it is true by the laws of logic that the current balance of payments always equals the public deficit less the private financial surplus, the only causal relationship linking the balances (given trade propensities) operates through changes in the level of output at home and abroad. Thus a spontaneous increase in household saving or a spontaneous reduction in the budget deficit (say, as a result of cuts in public expenditure) would bring about an improvement in the external deficit only because either would induce a fall in total demand and output, with lower imports as a consequence.

and also in The United States And Her Creditors: Can The Symbiosis Last? (link) from 2005:

A well-known accounting identity says that the current account balance is equal, by definition, to the gap between national saving and investment. (The current account balance is exports minus imports, plus net flows of certain types of cross-border income.) All too often, the conclusion is drawn that a current account deficit can be cured by raising national saving—and therefore that the government should cut its budget deficit. This conclusion is illegitimate, because any improvement in the current account balance would only come about if the fiscal restriction caused a recession. But in any case, the balance between saving and investment in the economy as a whole is not a satisfactory operational concept because it aggregates two sectors (government and private) that are separately motivated and behave in entirely different ways.

The European Commission has taken the report and produced another titled “Alert Mechanism Report” which has this table called “MIP Scoreboard” which highlights the imbalances in grey:

(click to expand in a new tab)

and makes observations on many individual nations – e.g., for Spain:

Spain: the economy is currently going through an adjustment period, following the build-up of large external and internal imbalances during the extended housing and credit boom in the years prior to the crisis. The current account has shown significant deficits, which have started to decrease recently in the context of the severe economic slowdown and on the back of an improving export performance, but remain above the indicative threshold. Since 2008 losses in price and cost competitiveness have partially reversed. While the adjustment of imbalances is on-going, the absorption of the large stocks of internal and external debt and the reallocation of the resources freed from the construction sector will take time to restore more balanced conditions. The contraction in employment linked to the downsizing of the construction sector and the economic recession has been aggravated by a sluggish adjustment of wages, fuelling rising unemployment.

The above is reminiscent of the Monetarist experiments of the 70s and the 80s where wages are squeezed by deflating demand (resulting in reducing employment instead of increasing it). No suggestion is made on how wages are to be negotiated. While I do not yet the best way to say the following, here it is: while wages are cost to firms, they are incomes to households and this strategy puts higher pressure on the fall in demand and creates a more recessionary scenario.

The Euro Area had no central government which is responsible for demand management in the broadest sense and individual nations having forgotten Keynesian principles, had haphazard policies from the start. In some nations, governments had a more relaxed fiscal stance but it was not seen in their budget balances because the domestic private sectors were happily involved in having its expenditure higher than income – adding to stronger growth and hence higher tax revenues. Thus the budget balance was seen under control. In others, this may have been the result of the private sector itself contributing to most of the increase in domestic demand by high net borrowing. The high growth in private sector incomes also led to deterioration in external balances of the weaker nations and the whole process was allowed to go due to irresponsible behaviour of the financial sector which was underpricing risk. Everyone was acting as if there was no balance-of-payments constraint (sectoral imbalances in general) which will hit hard someday.

When the crisis hit, governments realized that they had given up the ultimate protection (and simultaneously the lenders to governments) – making a draft at their home central bank.

Let me offer an intuition on sectoral balances in general and not just for the Euro Area. While it is true that a “good” sectoral balance is one in which all the “three financial balances” are near zero, it is important that policy be designed (and bargained at an international level) so that these balances are brought to their preferred paths of staying near zero in the medium term without affecting the aim of full employment.

So imagine a closed economy. Most economists would suggest that – under certain conditions – the government should design policy to aim to reach a budget surplus (or a primary surplus) but this comes at the cost of lower demand and higher employment and hence a poor strategy. A higher fiscal stance – as opposed to targeting a balanced budget – will automatically lead to primary surpluses in the medium term because of the increase in demand and national income leading to increases in the government’s tax receipts. In open economies this gets complicated. Under the current arrangement a unilateral fiscal expansion by a nation such as Spain is ruled out because this will bring about a return to high current account deficits because of a faster rise in domestic demand than domestic output putting the nation on a different unsustainable path.

Now this may sound like TINA – but it is not if one thinks of alternative strategies which are aimed at bring the three financial balances from getting out of hand but with a coordinated fiscal reflation. However, this is difficult without there being institutional means of achieving the desired outcome and hence there is an urgent need for a more integrated Europe with higher spending and taxing powers for the European Parliament (unlike the 2% budget rule of Charles Goodhart) which will be induced in substantial fiscal transfers. Competitiveness also needs to be addressed but the powers of the government go beyond fiscal policy alone and policies need to be designed in a more integrated Europe which reduce transfer addiction such as a common wages policy as suggested by George Irvin and Alex Izurieta in their article Fundamental Flaws In The European Project (August 2011):

Policy action is necessary if these trade imbalances are gradually to disappear. Crucially, labour productivity must increase faster in the deficit countries than in the surplus countries, an aim difficult to achieve unless proactive fiscal policy and infrastructure investment trigger a modernising wave of “crowding in” private investment. This means that Europe must redistribute investment resources from rich to poor regions. In addition, if higher labour productivity growth is to be achieved in the periphery, a “common wages policy” (not to be confused with a common wage) must be adopted which better aligns wage and productivity growth and sustains aggregate demand. This will not be achieved with wage disparities exercising a deflationary impact on the union. In the absence of national exchange rate realignment, adjustment must take place through a regional wage bargaining process.

Update: The European Commission background paper “Scoreboard For The Surveillance Of Macroeconomic Imbalances” is available at here

In yesterday’s post Spain’s Sectoral Balances, I briefly discussed the sectoral balances of Spain and its connection with demand, income and output. Here’s the original graph from the Banco de España again with my viewpoints in the previous post.

I learned some GIMP from a friend some time ago and thought I’ll use it for some fun.

I consider two scenarios:

Suppose the Spanish government relaxes its fiscal policy (independent of other Euro Area governments’ policies) or does not tighten it. How do the sectoral balances look? Here’s a likely scenario:

(may not sum to zero because of drawing discrepancies)

The “projection” – not to scale since I had limited availability for space – implies the government deficit keeps rising and this is the result of the rising current account deficit. A higher fiscal stance leads to a slightly higher income and employment but the flip side of this is a rising indebtedness to the rest of the world caused due to the current account deficits. The public sector is incurring almost all the change in net indebtedness – i.e., its contribution to net borrowing from the rest of the world is the highest.

Of course, this process cannot go on forever as a rising indebtedness implies foreigners have to be attracted by hook or crook and interest rate paid on government debt and consequently all private sector debts will also keep rising leading to a deflationary bust at some stage.

Also note, the causality here is a bit opposite of what was described in the previous post! The causalities between the balances of the “three sectors” is complex and not so straightforward. Here a higher fiscal stance leads to a higher income and expenditure and a widening of the current account deficit which in turn widens the budget deficit.

To prevent such possible instabilities – at least their smell of such instabilities – the European leaders have imposed the “fiscal compact” on nations.

What do they aim to achieve? The following “projection” is a possible answer:

The above describes the possible outcome of a tight fiscal stance of the Spanish government. A tight fiscal policy leads to lower income and hence a lower current account deficit – because of lower expenditure on foreign products – but it is achieved via lower output and employment.

The above projections are not based on a specific model for the Spanish economy but some analysis based on familiarity with SFC modelling.

Macroeconomics is not so easy – there are so many constraints – and governments have to strive to achieve the best optimal outcome. “Market forces” do not do that.

The second scenario can also be achieved by a coordinated fiscal expansion by the Euro Area nations. The sectoral balances may behave similar to the second scenario but in the expansionary scenario, output and hence employment is higher. Unfortunately there is no mechanism or institutional means by which fiscal policies are coordinated within the Euro Area (the exception is the recent “fiscal compact” which unfortunately misses the point). Even if there is an agreement on fiscal expansion, there is nothing to make sure that there is a constant management of the whole process – i.e., there are chances of failure.

There are various ideas one sees on proposing a solution to end the Euro crisis but almost none appreciate the real problems. In my opinion, there is no alternative to moving ahead with a European integration and granting more fiscal powers to the European powers – making it a central government – which is involved in fiscal transfers and a mandate to achieve full employment.